Why the IMF Cried “Uncle!,” and How Big Companies Are Preparing for a Euro Crash

Jack Crooks | Saturday, October 13, 2012 at 7:30 am

This week we witnessed an intellectual revolt by the International Monetary Fund (IMF), the key partner involved in this European crisis with the European Commission and European Central Bank (ECB), aka the Troika. And it validates my long-term, euro bearish view.

The IMF finally concluded that austerity measures are squeezing the life out of the euro-zone economy. Most of the economies imposing strict austerity are fading fast. They include: Greece, Portugal, Spain, and Italy.

Here is the policy path that the IMF had endorsed until its about face this week: A country with a massive welfare society can cut spending, while raising taxes and expect the economy to grow and produce more tax revenues.

That’s hardly how the real world works.

The IMF has finally realized that the path of austerity and tax increases leads to a viscous downward spiral of lower growth, lower tax revenue, more cuts, lower growth, lower tax revenue … etc. It is what many have been saying for a long-time and why most have predicted a Great Depression era settling over the zone.

I think this about face by the IMF exposes the primary flaw facing the euro zone — it is a structural competition problem.

Weaker Members Put
at Severe Disadvantage

All countries locked in the straightjacket of one monetary policy and one currency — the euro — are forced by the market to compete against one another based on the efficiency of their respective economies.

For example, granted a simplistic one, but to the point: If goods in country A can be produced more efficiently than similar goods by B, then A wins. In the real world, even if country B’s manufacturing industry is not as competitive, the country’s currency by virtue of a less efficient economy could fall in value relative to country A’s currency, thereby making B’s goods relatively attractive even though its labor efficiencies lag. Thus giving country B a chance to create some wealth in its competition against country A.

But the example above cannot play out in the euro zone — with Germany as country A, and weaker countries representing country B. Instead of using the currency, weaker countries must find a way to deflate domestic wages. This is what austerity has been all about …

The theory makes sense. But politically and economically thus far it has been devastating. And estimates are that this process may take a decade or more to pan out, which seems daunting given the level of social unrest and growing resistance among those distributing wealth.

So, the IMF stepped in with an intellectual lifeline of sorts. But it stretches only so far …

The idea of more spending will not do the trick. If that were the winning strategy, seven years of borrowing and spending during 2000 until 2007 by the weaker euro-zone countries would have helped their relative competitiveness. Labor efficiencies, based on wage rate productivity moved further out of line i.e. the gap for German competitiveness widened during the time weaker euro-zone countries had access to all the capital they needed.

When credit is flowing freely and consumers are spending wildly thanks to rising debt levels and not real wealth production … everyone is happy! And the structural competition problem remains effectively hidden.

But when you look at the numbers during the euro-zone consumer boom, you see that Germany filled a massive amount of this demand. And it is why Germany’s current account surplus was soaring during this period, while the other countries were recording increasingly bigger deficits.

The Key Point Is This …

In one sense it is good the IMF is finally acting like a grown up and pointing out that austerity is killing the euro zone. However, more spending by governments will not solve the core competitiveness problem. If the weak countries cannot create real wealth on their own, this game will end — the euro will break apart in time.

Based on our daily research, it seems more and more multi-national companies and analysts are coming around to the idea that there will be a breakup. The big companies — international and European based — are actually sweeping their cash accounts each night into what is perceived as stronger countries’ banks, and then bringing the cash back in the morning for operating capital.

Big companies are taking precautions in the event of a euro crash.

Many firms have either formed committees to monitor the ongoing breakup risk in the zone in real time or have drawn out strategic contingency plans to deal with a breakup, defining risks and costs.

JR and I have floated an idea before, which was a bit out of the box a year ago but now seems to be gaining some traction among analysts: If Germany leaves the euro zone, everyone would be better off, including Germany.

That’s because:

Countries competing with Germany cannot compete using the same currency. And if Germany leaves and the D-mark rises in value against the remaining currencies, as most suspect it will, then those still using the euro will be able to compete on final goods exports. And even on a foreign direct investment basis in a much devalued euro relative to the D-mark, their assets will look cheap.

Moreover, the incentives for Germany to remain the paymaster within the euro zone are fading fast …

German taxpayers are grumbling. And the country’s central bank — the Bundesbank — is not happy. The way the payment system is structured in the euro zone between the ECB and Bundesbank, Germany takes on a huge risk, now estimated at around €900 billion and rising. And as the euro zone craters down into another deep recession, the zone loses its captive export market appeal for German manufacturers.

So, I believe this week’s admission by the IMF that austerity is the wrong policy to correct what ails Europe is a damning admission. It says to the world that to date, those umpteen summits designed to impose just the right amount of austerity to trigger recovery and confidence the single currency was “here to stay” were nothing more than a massive waste of political, and more importantly, economic capital.

Plus, they were a waste of a very precious commodity for the euro zone — time.

So Now What for the Euro Zone? Two Possibilities …

There might be a new round of massive fiscal spending that may stabilize the zone and reduce social unrest. At the same time, though, it will push debt-to-equity ratios even higher from an already very lofty perch. But it would be an admission the welfare state cannot be dismantled anytime soon. And from a pure supply and demand standpoint, it will mean a much bigger supply of euros will be thrown onto the market. That alone should lead to a lower price for euro relative to all currencies.

Or …

Leaders in key countries come to their senses and realize if they had control of their own currencies and monetary and fiscal policies, they could design economic policies better tailored for their own needs to help their industries compete on their own terms. If that conclusion is reached by a critical mass of countries, based on the implicit and unintended backing of the IMF, this thing called the euro would unravel quickly.

We think the first possibility is the more probable: A massive number of euros will be thrown on the market by the ECB and increased fiscal spending will follow. The law of supply and demand would then take over, and the euro falls of its own weight.

Best wishes,

Jack

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{4 comments }

Richard GordonSaturday, October 13, 2012 at 9:40 am

Interesting article. I used to think that the Euro was doomed, and like you I felt that the best option was for Germany to exit. At least that way, the prevailing contracts would be honored and total financial chaos would be avoided. For all the reasons articulated in this article, it makes sense that it would be Germany that exits and the rest of the Euro-zone that stays together. Greece, Portugal, Italy or Spain alone would simply not survive on their own. So this option is always open if the worst comes to worst and Europe flies apart at the seams.

However, as the crisis has unfolded, I have also been impressed by how committed Europeans are to the the Euro. This commitment is underscored by Greece’s point blank refusal to give up on the Euro even thought they are going through absolute hell. Even in Germany the perception is that the Euro is the future and the D-mark is the past.

The silver lining in a crisis like this is, that countries like Greece and Spain are forced to reform their economies and make structural changes that would be politically impossible under any other circumstance. And there are positive signs that changes are taking place.

In the end I am leaning towards the Euro surviving, and the IMF’s statement is signalling to the PIIGS that relief will shortly be on its way. Its also sets the stage for Germany and the Bundesbank to tolerate more monetary easing. Germany is pathological in its fear of inflation, but like it or not, moderate inflation (2-3%) is really the only solution to rebalanced the European debt crisis.

Europe, like the United States is between a rock and a hard place, the debt to GDP ratios are completely unsustainable and there is only two solutions that can change that. Pay the money back (austerity) or print money and inflate away the debt. So my view is that Europe is taking the middle path. Austerity to force the necessary reforms and mild inflation to reduce the debt to GDP ratio.

I also think that ultimately Europe will form a closer political and fiscal union, but only when austerity has done what it needs to do to force the necessary structural changes.

ed the grocerSaturday, October 13, 2012 at 7:35 pm

The currency differences was the problem in the first place. Politicians, unions, and companies didn’t have to think. Want more money? No problem. Just give in and it would all be sorted out with the exchange rate. Except there are large inefficiencies in borders and money changing that simply sucked many percent out of the entire area. The overall intent is to create a large and powerful production area that can compete with the world. The only problem is that the people inside have to go to work or go to the beach. And if you go to the beach it might be as a bum.

Brian the king of financeMonday, October 15, 2012 at 10:57 am

Although I personally don’t like the idea, my view is also that the road to be followed by the Euro-zone will be that of much closer political and fiscal union. That’s the only way that eiltes presently in power will stay that way.

One important consequence of close political and fiscal union that no one wants to talk about is what that fact would mean to populations within the Euro-zone. In a nutshell, it means that areas of decreased economic vitality would see significant emigration while areas of increased economic vitality would see immigration.

How do we know this? It’s because that’s what happens in the US, where the federal currency (the dollar) pre-empts any ability for economically-deprived areas (like Michigan, for example) to devalue a local medium of exchange to attract investment. Consequently, we have migrations of people away from former industrial areas in Michigan to newly industrialized areas in the south, which is well-known for its inferior wages and benefits.

It’s not too much of a problem in the US because there is but one primary language and social norms have been homogenized over the past century. Not the same is true with Europe, and anti-immigrant sentiments are much worse there than here.

Not the type of situation that lends itself to social harmony. It’s the opposite.

s loebsTuesday, October 16, 2012 at 12:07 pm

Good article, Jack. Don’t forget that Iceland has been the bright light of opposition to the austerity policy in Europe. The people of Iceland vote on the nonbinding constitutional reform referendum this Saturday October 20th!